Making Your Money Last


Cash Reserves Can Extend Nest Egg's Life

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With savings accounts and certificates of deposit continuing to pay next to nothing, you may fret that you'll throttle your nest egg if you follow the widespread advice to maintain a cash reserve of up to a year for expenses. No worries: A new study shows that your nest egg may actually last longer if you keep a one-year cache of cash.

See Also: Thumbs Down on a Retiree Rule of Thumb

Researchers found that both taxable and tax-deferred accounts with cash reserves generally have better survival rates over a 30-year retirement than accounts without a cash allocation. Portfolios that include cash are better able to withstand the impact of taxes, transaction costs and volatility, the researchers found.

Many financial advisers have long recommended cash reserves as insurance against investors having to sell investments in down markets to cover expenses. Others, however, counter that large cash reserves earning close to 1% or less crimp a portfolio's performance. The latest study shows that when the costs of taxes and trading are taken into account, having a cash stockpile can more than offset the higher returns produced by investing the cash in other assets.

The researchers compared two $200,000 retirement nest eggs. One had an allocation of 60% stocks and 40% bonds. The other nest egg had two buckets. Four percent of the portfolio was allocated to cash, enough, at a rule-of-thumb inflation-adjusted 4% withdrawal rate, to pay for expenses for a year. (Presumably, the retiree had to supplement the $8,000 expenses reserve with Social Security, pension payouts, rental income or a part-time job.) The other bucket was allocated to stocks and bonds at slightly lower percentages than the first nest egg. In one scenario, the retirees' assets were in taxable accounts, while in another they were in tax-deferred accounts, such as an IRA or a 401(k).

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Assuming an inflation-adjusted 4% withdrawal rate, the tax-deferred account without a cash reserve had a 55% chance of surviving 30 years, compared with 59.4% for the tax-deferred account with the cash reserve. The non-cash nest egg incurred a median $21,600 in transaction costs over 30 years, compared with a significantly smaller $2,520 for the nest egg with the cash reserve.

Cash was king as well when both nest eggs were in taxable brokerage accounts. The survival rate for the account with the cash reserve was 66%, compared with 60% for the account without the cash bucket. The transaction costs were similar to those in the tax-deferred accounts.

The accounts without the cash reserve had considerable trading costs because the investment portfolios needed to be tapped every month for expenses, says study co-author John Salter, associate professor of personal financial planning at Texas Tech University. Each trade was assumed to cost $30, far more than fees charged by discount brokers but less than typically charged by full-service brokers. The study assumed two trades each month.

Slashing Transaction Costs

Meanwhile, stocks and bonds in the accounts with the cash cache were tapped once a year when the reserve needed to be replenished. "Instead of transaction costs 12 times a year, we're incurring those costs only once," says Salter, who also is a certified financial planner at Evensky & Katz Wealth Management, in Lubbock, Tex. Co-authors were Harold Evensky, president of the firm, and Shaun Pfeiffer, associate professor of finance at Edinboro University, in Edinboro, Pa.

For the taxable accounts, the median tax bite over 30 years was slightly higher for the nest egg without the cash reserve—$73,993 compared with $71,886. All the trades were assumed to incur 15% long-term capital gains. One reason for the higher tax tab: More income comes from the stocks and bonds than from the cash. In an actual portfolio, accounts without the cash reserves would likely rack up more taxes because some of the monthly trades would throw off short-term capital gains, which are taxed at ordinary income tax rates of up to 43.4%, Salter says.

Salter says that for many years, his firm set up two-year cash reserves for clients. The more cash, the lower the transaction costs—but "there is also an opportunity cost of more cash not being invested," he says. In today's markets, he says, "one year ended up being the optimal solution to the tug of war."

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